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Canadian Credit Health Update

2013 Q3


Go to the most recent report: 2016 Q4

Health of Canadian banks: stable (green)

Introduction

These Canadian Credit Health Updates are released every quarter. In these reports, I apply the same analysis techniques that I used when watching the American financial system through 2005-2009. These metrics should show early warning signs of impending bank losses or even a banking crisis, just as they did in the USA. All data comes from public financial reports.

There are significant changes to this report's structure starting in 2013. I have re-examined metrics for solvency and risk, leading to more meaningful numbers and better comparisons in the tables. National Bank of Canada is now also included.

Summary for 2013 Q3

Notes on capital levels and leverage



Changes in Methodology

The changes revolve around the definition of “bank capital”. Please read my article about measuring bank capital for a technical description of the new measures, with references.

Starting in 2013, the value used for bank capital will now be Common Equity Tier 1 (CET1) capital from Basel III guidelines. This is a new, stricter definition of bank capital that is very similar to “tangible equity” or “tangible common equity” (TCE). I believe this is the best standardized value to use for bank capital, especially under stress. I am using the all-in number.

Leverage is now calculated differently: Assets divided by CET1 capital. For example leverage of 33:1 means that a bank has 33 times as much assets as core equity capital. The new measure, a straightforward ratio, is more intuitive and far less susceptible to manipulation by banks. The Canadian banks report regulatory capital ratios based on risk-weighted assets (RWA), which some experts believe is virtually meaningless due to all the flexibility in determining RWA. I believe my measure is better and more meaningful, and regulators are expected to introduce something similar in 2019. The FDIC's Thomas Hoenig endorses a measure that is nearly the same as mine.

My comments on bank capitalization are based on the (very conservative) CET1 capital number and non-risk-weighted assets.


Big Six Banks: Balance Sheet Health

Definitions: GIL = Gross Impaired Loans, CET1 = Common Equity Tier 1

Table A. GIL / Gross loans (higher = worse loan book)

This is a rough measure of how bad the loan book is, looking at impaired (non-performing) loans. Before 2008, these values were under 1%^. Presently, the values are quite low but this is a bit artificial: banks exclude some US packaged loans/debt securities, and those non-performing amounts aren't included. New accounting standards^ have also made these numbers look better.

Bank

2013.Q3

2013.Q2

2013.Q1

2012.Q4

2012.Q3

2012.Q1

2011.Q4

2011.Q3

2011.Q2

2011.Q1

2010.Q4

2010.Q3

National

0.39%












RBC

0.50%

0.54%

0.54%

0.58%

0.55%

0.62%

0.78%

0.79%

1.31%

1.54%

1.65%

1.68%

TD

0.60%

0.58%

0.59%

0.60%

0.57%

0.63%

0.70%*

1.32%

1.34%

1.43%

1.23%

1.24%

CIBC

0.63%

0.67%

0.69%

0.73%

0.76%

0.79%

0.94%

0.91%

0.92%

0.98%

0.99%

1.09%

Scotiabank

0.90%

0.89%

0.91%

0.95%

0.98%

0.99%

1.32%

1.38%

1.43%

1.47%

1.50%

1.86%

BMO

0.97%

1.07%

1.12%

1.15%

1.12%

1.09%

1.29%

1.11%

1.58%

1.71%

1.80%

1.78%

Average

0.66%












Avg Big Five

0.72%

0.75%

0.77%

0.80%

0.80%

0.82%^

1.01%

1.10%

1.32%

1.43%

1.43%

1.53%

^ Note: banks switched accounting standards in 2012.Q1 (impaired loans were stable; they didn't suddenly improve)
* I think several banks are under-reporting impaired loans; BMO “excludes Purchased Credit Impaired Loans”, and TD is under-reporting impaired loans in U.S., see details in 2011 Q4 report.

Table B. GIL / CET1 capital (higher = greater risk of failure)

Similar to the Texas Ratio, a measure of bad loans versus the bank's capital. Around the 100% mark, a bank's capital cushion is no longer adequate to absorb loan losses. This ratio is believed to be an early warning signal for bank failures, though the ratio has to get quite high before solvency is threatened.

Bank

2013.Q3

2013.Q2

2013.Q1

RBC

7.1%

7.7%

7.6%

National

7.2%



TD

10.5%

10.3%

10.3%

BMO

12.8%

14.1%

14.6%

CIBC

13.0%

13.8%

14.5%

Scotiabank

14.6%

15.1%

15.8%

Average

10.9%



Avg Big Five

11.6%

12.2%

12.6%

Table C. Leverage multiple (higher = more leverage = more risk)

Higher leverage means a bank is more susceptible to sudden shocks, and is less capable of handling losses. High leverage means a bank has less capital; conversely, low leverage means a bank has more capital. Leverage = Assets / CET1 capital (see technical details) and is sometimes stated as N:1 or N x leverage.

Bank

2013.Q3

2013.Q2

2013.Q1

BMO

26.6

27.5

27.3

RBC

29.3

30.7

29.8

Scotiabank

29.5

31.4

32.0

CIBC

31.8

32.4

32.5

TD

32.9

33.5

33.7

National

35.8



Average

31.0



Avg Big Five

30.0

31.1

31.1

Off Balance Sheet Derivative Exposures

Amounts are in trillions of dollars. All amounts are notional, which is the face value of a contract (the amount of underlying money represented by a contract). These are not prices or market values of contracts. In other words, $1 trillion of notional exposure does not mean the bank could lose $1 trillion; however, it shows the magnitude of derivative contracts. For instance, RBC most certainly has a larger derivatives book than any other bank and likely faces more derivatives risk than others.

OTC exposures are included here because I believe OTC contracts are the most dangerous since they are illiquid, difficult to value, and become worthless if the counterparty (another bank) collapses.

This derivative exposure is hidden off-balance sheet where it can't distress investors and depositors. The standard excuse given by banks is that they are long some derivatives, and short others – and the two (thanks to financial engineering) perfectly balance out risk, resulting in minimal net exposure. But in reality, banks can only maintain such perfect hedging during exceptionally low volatility. A spike in volatility, or a counterparty failure, can suddenly create enormous derivative book losses. This happened in 2007-2009 (wiping out several banks), and will probably happen again. More derivative exposure means more risk.

The below data comes from: OSFI, financial data – banks, quarterly derivative components.

Bank

2013.Q2


Total notional

OTC notional

RBC

$7.40 T

$7.04 T

TD

$4.07 T

$3.68 T

BMO

$3.38 T

$3.26 T

Scotiabank

$2.79 T

$2.57 T

CIBC

$1.84 T

$1.76 T

National

$0.54 T

$0.45 T

Total exposure

$20.02 T

$18.76 T

Bankruptcy Statistics

These numbers show total Canadian bankruptcies (consumer + business). Bankruptcy rates closely relate to bank loan quality and losses. Note however that banks with significant US/international operations have further credit exposure beyond Canada, which isn't reflected in this graph.

The volatile monthly data is smoothed using a trailing 6 month average (moving average).

Bankruptcy rates have been declining since 2010. However, the trend is currently rising. This is now the largest increase since 2009 Q3 and must be closely monitored to see if bankruptcy rates have reached a multi-year turning point. I believe it's too early to tell.


- Perpetual Bull, perpetualbull@gmail.com